How does one calculate inflation?

TNN Aug 9, 2004, 04.55am IST

What is a price index? If you need to know how much the price of a particular commodity has
increased in, say, the last year it is a simple enough computation.
However, if you need to give a figure for the increase in prices over a range of commodities,
things obviously get more complicated, since individual commodity price variations are likely to
be quite different. You could choose to say the price rise ranges from, say, 4% to 26%, but that is
clearly less meaningful than if you could put a single number to it and say prices have on the
whole risen by 8.3%.

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The purpose of a price index is to let you do just that. It does that by assigning different weights
to prices of various commodities, so that you can get a weighted average of the price increases.
The weights are needed because you surely wouldn't want the price of a tube of shaving cream
ticket to be equated in importance with the amount you spend on petrol over a month.
Why do we need so many price indices?
There are different levels at which prices can be measured. The price of your vegetables is
different for the wholesaler who buys it from the farmer, the retailer who gets it from the
wholesaler and for you. We need different indices, therefore, to measure what is happening to
prices a each of these levels. In India we have the wholesale price index (WPI) to track
wholesale prices, as its name suggests, and three different consume price indices to track prices
facing different categories of consumers industrial workers, urban non-manual employees and
agricultural workers. The different CPIs are needed because the prices facing different consumer
groups are different. Thus, while urban house rents may be of great significant to the first two
groups, they would be of no consequence to farm labour. Thus the composition of each CPI is
different and should ideally reflected the actual consumption patterns of the relevant consumer
groups.
What is the inflation rate we keep reading about?
What is generally reported is the annual point-to-point inflation rate, which measures the change
in the level of a price index over a full year. The CPIs in India are computed on a monthly basis,
while the WPI is computed every week. Unless otherwise indicated, the inflation rate being
referred to is normally the one based on the WPI.
The year in this case would be 52 weeks.
Thus when the papers report that inflation for the week ended July 24, 2004 was 7.5%, what this
means is that the WPI for that week was higher by 7.5% than the one for the week ended July 26,
2003. It is important to realise that the point-to-point inflation rate reflects only the difference in
prices over two specific weeks. Hence, if the inflation rate moves up from one week to the next,
it need not mean that prices have actually moved over that period.
It may equally be because there was a fall in the corresponding period of the previous year.
This also explains why economists prefer to deal with average annual inflation rates rather than
with point-to-point rates. Since the former involve averages of the index over longer periods,
temporary blips are evened out, giving a more realistic picture of the trend.
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What is the composition of the WPI?
The WPI has an All Commodities Index, which consists of four three major groups - Primary
Articles; Fuel, Power, Light & Lubricants; and Manufactured Products. These are again broken
up into smaller sub-groups. For instance, the primary articles group would have food articles,
non-food articles and minerals. Each of these sub-groups would have several individual
commodities in them.
All told, the current WPI tracks prices of 435 commodities, of which 98 are primary articles, 19
fall in the fuel, power, light & lubricants group and 318 are in the manufactured products group.
The WPI has been periodically revised from the time it was first constructed in the 1930s and for
obvious reasons the weights have moved progressively in favour of manufactured products.
The current index, which uses 1993-94 as its base year, has weights of 22.025 for primary
articles, 14.226 for fuel etc and 63.749 for manufactured products.